In this article written for Executive Briefing, David Bolchover asks whether senior executives of distressed banks now facing pay caps are really as talented as they claim.

Bailed-out bank bonuses: right or wrong?

After a short interval, high pay awards in financial institutions have returned to the headlines. One of the first acts of President Obama’s new administration has been to announce curbs on senior executive pay for those companies receiving federal bailout money. Meanwhile, in the UK, companies that have received billions of pounds of state aid have provoked widespread uproar by preparing to pay out tens of millions of pounds in bonuses to selected staff.

Is President Obama’s course of action the correct one? Will the policy not only hurt individual bankers, but also the banks themselves? What are the central arguments of those who attack the Obama plan and defend the proposed payouts to the UK bankers in bailed-out institutions? Do these arguments stand up to scrutiny?

The nuts and bolts

The details of Obama’s policy announcement are wide-ranging. The main highlight is a $500,000 pay cap on senior executive pay in any company that negotiate agreements with the Treasury Department for “exceptional assistance” in the future. It does not yet appear clear who qualifies for the label of “senior executive”.

The restriction would not apply to firms that have already received such assistance. Firms that wish to reward their executives with more than $500,000 would have to use stock that could not be sold or liquidated until the companies pay back the government funds. Companies that seek some capital infusions from the Treasury, but are in a less desperate state, will be allowed to waive the $500,000 limit with full public disclosure and a nonbinding shareholder vote.

Other restrictions to be imposed on companies seeking “exceptional assistance” include a ban on golden parachutes (payoffs) for its top ten senior executives and a requirement that boards of directors adopt policies on spending such as corporate jets and entertainment.

While the Obama administration was making headlines in the United States with this clampdown, it was reported that The Royal Bank of Scotland, rescued with £20 billion of public money, is reported to be planning to award large bonuses, amounting potentially to hundreds of millions of pounds, to thousands of its traders and senior bankers. UK Financial Investments, the Treasury-run body that holds the Government’s stake in RBS, is understood to have approved this payout in principle. Lloyds, which has taken £17 billion from the State, is also, apparently, on the verge of distributing similar rewards.

Arguments for and against

President Obama’s motivation for this policy seems obvious. The electorate would be understandably angry if taxpayers’ money, yet more hard-earned in these straitened times, was used to line the pockets of employees of companies which have been rescued from oblivion by that very same money. Obama is playing to an extremely appreciative gallery when he says: “What gets people upset, and rightfully so, are executives being rewarded for failure. Especially when those rewards are subsidised by US taxpayers.”

Some supporters of the plan might claim that it is not sufficiently wide-ranging. Firstly, it appears that those companies that have already been bailed out, such as Bank of America Corp., American International Group Inc., and Citigroup Inc., will still, in theory, be free to dole out huge rewards to senior executives.

Secondly, many of the highest-paid staff at financial institutions have not been “senior executives” (whatever the eventual definition of the term), but traders and dealmakers operating at the cutting edge of the business. The bonuses earmarked for RBS and Lloyds employees, for example, will be for areas of the business, such as foreign exchange dealing, where large profits are still being registered. Indeed, it is the high remuneration outside the executive tier that most irks President Sarkozy, the French president: “I’m more shocked by the system of bonuses for traders than pay to bank bosses. That’s what we need to change,” he said.

Bailed-out US banks, as their UK counterparts are already doing, might at some stage seek to distribute rewards to these profit-generating employees that exceed the pay limits imposed on “senior executives”. Their defence will doubtless be that their company, already in dire straits, would find itself in an even more disastrous position if those few employees who were actually bolstering the company’s finances were tempted to join a competitor offering them a larger salary.

Critics of the Obama plan are articulating similar arguments right now in respect of senior executive pay. These troubled companies, they say, require the most “talented” executives available to turn their fortunes around. Perhaps the executives at the helm when their companies got into this mess have a moral responsibility to accept lower pay at this juncture, but what about “talented” executives considering joining the same companies now? For a measly $500,000 a year, they are being asked to invest the huge personal effort needed to help revive their performance and balance sheet. Why would they want to do that when they can earn more money, and easier money, elsewhere?

Jeffrey Immelt, chief executive of General Electric, summarised the views of those who feel the suppression of executive pay is counterproductive: “(Government) should want to have the best people on earth running these banks,” he said. “I just think capping pay isn’t conducive to making that happen.”

Another unnamed top Wall Street Executive told The Financial Times that "the cap is a lousy idea,” arguing that “if there is no monetary upside, who would want to do these jobs? Executives will just move to private equity and hedge funds.”

Mr. Immelt, who received total compensation of around $20 million in 2007, Wall Street and City of London workers, not to mention the army of recruitment agents and remuneration consultants who feed off the system, all have a vested interest in promoting the commercial rationale for preserving high executive and trader pay. But are they right?

A question of talent

On the surface, their argument might seem convincing. They are asking us to forego our emotional reaction, never a sound basis for prudent decision-making, and think logically and commercially instead, just as they want us to believe that they do. For our economy to prosper, we need strong banks, and we need the best people to make them strong.

To attack this argument on an intellectual level, we must confront head-on the self-serving ideology of “talent” that has been enthusiastically espoused by high-earning white-collar employees. This ideology holds that the skills and experience of able senior executives and traders is extremely rare, as the word “talent” implies, and not easily replaced. Hence the alleged necessity to reward them commensurately.

There are three reasons to refute the “talent” justification of Immelt and friends. Firstly, this was the same argument used over the last decade or more to defend the extremely high pay of the senior executives and traders in financial institutions whose actions later destroyed their companies and destabilized the global economy. They were making vast profits at the time, rendering the argument much more persuasive. In retrospect, the same argument seems nothing more than an elaborate con-trick. Why should we accept it now?

Secondly, there are now large numbers of former financial sector employees who are now out of work and desperate to find another job. Does it stretch the imagination too much to believe they could be retrained relatively quickly in the disciplines required by the still profitable segments of the industry? Or are we saying that foreign exchange dealing is such a sophisticated art that it is beyond the potential mastery of intelligent, well-educated people?

Thirdly, financial institutions now require senior executives to exhibit skills and experience that will be impossible, right now, to prove they possess. These executives will have never before been asked to turn around companies in such a poor financial state. Leading successful companies in a prosperous economic environment was an entirely different proposition, requiring entirely different attributes. Rewarding senior executives in the future for returning the company to healthy long-term profitability may well be entirely justified. But paying top dollar now for proven experience is indefensible, because nobody has that experience.

One could argue that the ideology of talent was the ultimate cause of the current global economic downturn. It paved the way for huge short-term rewards which in turn induced widespread and perilous risk-taking. The very same ideology might now turn out to be the sole biggest victim of the very same downturn.